Article / 15 August 2016 at 12:12 GMT

Volatility Update: Market chops while volatility drops, what's next?

Product Manager, Options Trader, Educator
  • US equities up 4% during earnings season
  • Yield-hungry investors piled into telecoms and utilities
  • VIX fear index made 52-week low, investors getting edgy
By Georgio Stoev

The market is quiet with earnings season at conclusion. Despite this, US equities (SPY) are up 4% since July 1 – the official kick off of second quarter earnings. We held two OptionsLab webinars dedicated to earnings in recent weeks. The main driver for this performance was the relative strength of technology and financials posting some respectable earnings. 

Selected sectors/asset classes as of August 12


Source: SaxoBank

One could argue that the bull market is resurrected as of early July, at least technically speaking, after a one and half year pause. The strength in the broad-based Russell 2000 (IWM) is a good indication of this argument. In search of yield many investors have piled up gigantic amounts of cash in telecom stocks and utilities, as supported by the sector's performance (XLU) up 20% YTD. But as stocks hit record high levels fear might be creeping back up among investors. 

Trader's jitters

At the Chicago Board Options Exchange a flagship measure of volatility (VIX) seems to be anaemic and continuing to drop. On Tuesday, the fear index made 52-week low of $11.02 and investors are starting to get uncomfortable. 

VIX Daily
Source: Saxo Bank

Rewind back one year to August 2015  we are sitting near the same levels of VIX. The market jitters of last August are still in the rear-view mirror and traders are looking to protect themselves against another possible market havoc. According to the OCC, the put-to-call ratio on the SPX (S&P 500) reading on Friday 1.5. 

As a reminder, the ratio takes the total volume of put options and divides it by the total volume of call options. A ratio of 1 indicates that the volume of put to calls is equal. If the reading is higher than 1 it indicates that there is more puts traded versus calls. The higher ratio of 1.5 may suggest that investors are positioning themselves for a bearish move. That's not always the case, however, as many investors will extend to purchasing puts to secure their equity holdings (see "Protective Puts Explained"). Investors could sell puts as a means to purchase stock, as well. 

Volatility Measures

Implied versus historical 
E-Minis Volatility
Source; Bloomberg, Saxo Bank

Another look at volatility could help us read the market a little better. While the implied volatility (expected) for E-mini options is anchored at a 52-week low, the historical volatility (realised) has fallen to new lows. As the historical volatility is derived from the actual underlying price, the implied volatility is the expected future market move. 

When analysing the two it is important to determine not only the direction of the two, whether they are rising or falling, but also the relative levels. For instance the IV of the E-mini options is currently sitting near $10 and it has been three other times in the last year. The HV volatility, however, is making a fresh 52-week low. With such reading, traders may realign their expectation of the market and assume that the market is not going to move much in the next 30 days.  

Volatility skew

The distribution of implied volatility across exercise prices is known as volatility skew, smile or smirk, depending on how the line is shaped. The distribution of the IV largely depends with which options traders decide to work with. 

Most investors are holding equity shares and naturally are concerned about the risk of markets falling. To protect themselves against a potential fall in the market they will either purchase a protective put or sell a covered call. But what strike prices would they choose in protective put or covered call? An out-of-the money put costs less than in-the-money put but it will offer less of a protection. Buying OTM puts would work well if the investor feels that overall prices of the underlying will rise over time but some bumps ahead are expected. If the same investor expected a free fall than selling the underlying position would provide the "best" hedge. 

A covered call strategy will almost always include a higher exercise strike price. This will offer less protection than the selling of the ITM options to an investor. Here again the investor believes that there might be a short-term correction but overall he believes that the price of the underlying will rise over time. 

The above hedging activities, there tends to be more demand on buying lower strike prices (purchase of protective puts) and selling pressure on higher strike prices (covered call). This causes the IV of lower strike prices to rise and the IV of higher strike prices to fall. This is referred to the skew to the downside.

volatility smile

Currently, he volatility skew for the E-mini options currently could suggest that deep OTM puts are becoming more expensive, e.g puts with delta of 5. At the same time, call options, particularly deep OTM, have become cheaper. 

Inverse skew
While investors are looking to protect themselves with deep out-of-the money puts, as in protective put, selling covered calls using OTM calls may not provide much of a hedge these days. As volatility falls, all things equal, so does the premium in an option. Hence, there might not be a big advantage in selling covered calls. 

For investors who want to go long stock selling out-of-the money put options, as in cash secured puts or in combination of another put (bull put spread), might be a good way to take a position in the market. In a cash-secured put, investors will look at a short-term dip in underlying asset followed by a longer-term appreciation. For instance, if investor wanted to purchase shares of Netflix at $95 while shares are trading currently at $96.59, he could sell September 95 put and receive $2.81 (Friday close). With 32 days to expiration if the investor gets assigned he will purchase the share at $95 and receive $2.81 per contract. The premium that he received for taking on the risk further reduces his cost basis in the stock ($95-$2.81= $92.19). 

More sophisticated strategies in a low volatility environment are calendar and diagonal spreads in which investors are looking for the volatility to expand over time. Check out our webinar on diagonal spreads with Shawn Howell.

Have a great week ahead!

– Edited by Clare MacCarthy

Georgio Stoev is futures and options product manager at Saxo Bank 


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